Monday, July 11, 2011

The world is obsessed with the problem of too much debt and the threat it poses to the civilized world. Greece is very likely to default on its debt, and so are Ireland and Portugal. Meanwhile, the U.S. wrestles with its own burden of debt. Total outstanding debt owed by the U.S. government to the public now stands at $9.75 trillion, or about 64% of GDP. That’s the highest level of federal debt relative to the economy since the early 1950s, when the U.S. government was working off its huge debt (well over 100% of GDP) incurred while fighting WW II. If the federal deficit continues at the current level of 9-10% of GDP, total debt will exceed 70% of GDP one year from now, and eventually it could exceed GDP.

Does all this debt and its attendant problems mean the economic outlook is inescapably bleak? Will PIIGS defaults result in a collapse of the Eurozone banking system? Will debt default contagion bring about another global recession? Will debt defaults intensify lingering deflationary pressures? The short answer is that most of the bad effects of too much debt have already happened.

Debt has certainly become problematic, but the threat it poses to the world is likely being exaggerated. That’s because there are a number of popular misconceptions about debt, and because many ignore that the market has already factored in the likely consequences of defaults.

Debt is a zero-sum game, since one man’s debt is another man’s asset. Debt is an agreement between two parties to exchange cash now with a reversal of that exchange, plus interest, in the future. If the borrower fails to repay his debt (i.e., he defaults), then the borrower benefits by being relieved of some or all of his debt service obligations, and the lender suffers by not receiving some or all of his expected cash flows. Part of the interest the lender charges the borrower goes to offset the risk of default.

Debt payments by a borrower are not equivalent to flushing money down the toilet. The money borrower B pays to lender A is money that A will spend on something else. The amount of money available to the economy doesn’t change when debt is serviced or paid off. Demand doesn’t change, money simply changes hands. Similarly, the issuance of new debt does not create new demand. When A loans money to B, A must spend less in order for B to spend more.

Credit expansion is not the same as money creation. Central banks, not credit markets, control the amount of money in an economy. They typically do this by targeting the price of money (e.g., short-term interest rates), and that in turn increases or decreases banks’ ability to lend, and increased bank lending is what leads to new money creation. Credit expansion does not create any new money because the issuance of new debt only causes existing money to change hands.

Credit outstanding can grow faster than the amount of money in an economy without there being any inflationary consequences, because credit does not create new money or new demand; it simply redistributes existing money. Similarly, credit contraction can occur without there being any decline in overall output or any deflation, provided the central bank is properly overseeing the amount of money in the economy. Credit contraction, aka deleveraging, is a sign of increased money demand, which should be offset by an increased supply of money. The Federal Reserve has been doing exactly this with its quantitative easing program: responding to the private sector’s desire to reduce its debt burdens. That's why quantitative easing to date has not been inflationary.

Borrowing with new debt can be a good thing for both parties to the transaction, provided borrower B spends the money that lender A saved on something productive. Investing in productive assets or activities generates the cash flow that is needed to pay the interest on the debt. Debt can be a drag on growth, however, if B spends the money on something unproductive. For example, Greece has borrowed hundreds of billions over the years, in part to fund generous retirements for people who retired at a relatively young age. Greece now finds that its economy hasn't grown enough to generate the cash flows it needs to repay its debt. The damage has been done, and no amount of EU assistance to Greece can alter the fact that Greece in effect “wasted” the money and has nothing to show for it. Borrowing money only to spend it on unproductive things is already reflected in the slow growth of the Greek economy; Greece has been squandering its scarce resources. Markets now understand that a default is highly likely and have already priced in a significant Greek default.

A nation that defaults on its debt does not necessarily need to suffer a decline in its GDP or national income. GDP is determined primarily by the number of people working and the productivity of their labors. Debt defaults and/or restructurings can lead to positive outcomes if steps are taken to increase productivity. Relieved of some of the burden of its debt, but much less likely to qualify for new loans, Greece could move forward by cutting spending, trimming retirement benefits, and encouraging new investment and business formation. Many unproductive retirees may need to go back to work, and they might be encouraged to do so if enough new and attractive jobs are created.

If Greece's creditor banks fail to receive their expected cash flows, many may go out of business. But that won't change the cash flows and the incomes that are being generated by all the people working in the world. The PIIGS may end up defaulting on hundreds of billions of debt, but that won’t necessarily cause Eurozone GDP to decline; it’s already depressed because the money that was borrowed was spent unproductively. If anything, the painful restructuring that would inevitably follow in the wake of a default would likely result in higher living standards in the future. The world has survived large sovereign debt defaults many times in the past without disastrous economic consequences. Argentina's 2001 default on $132 billion comes to mind.

The disruption and fear that may be generated by bank failures could, however, disrupt growth insofar as investors become reluctant to accept risk and prefer instead to buy risk-free securities from governments like ours that have dubious uses for the money. Come to think of it, that has been happening a lot in recent years—Treasury has been borrowing trillions at extremely low interest rates from lenders seeking to minimize their risk, and spending the money in ways that are much less productive than if the money had been put to use by the private sector. The damage has been done, and it is reflected in disappointingly slow growth and relatively low valuation multiples.

In short, much of the disruption that can be expected from debt problems has already happened. Instead of fretting about defaults, the world should turn its attention to the aftermath of default, the new policies and adjustments that will be required, and the brighter prospects that these will entail for the future.

Excellent, Scott. I agree 100% in your analysis of debt and money. The damage has already been done. One question, though. While you address the contagion effect in a glancing fashion, this is what US markets fear. What is the exposure of US banks to European banks? Is it enough to take them down if there is a default, and if that happens what is the impact on the US economy? If the Fed injects money, can that offset the problem without collateral damage? This probably needs some more fleshing out. What is interesting to me is that Europe is on fire and the Dow is trading near 12,400. Looks like our markets understand exactly what you are talking about.

According to your logic, the US can also just go ahead and default and it won't necessarily cause the US GDP to fall.

And in terms of Greece defaulting, no, you are very wrong. Most of the damage has NOT been done. A majority of Greece outstanding debts were issued prior to 2009 when yields were normal. If Greece defaults, creditors holding those issued earlier would take significant haircuts.

Scott, while your analysis is once again spot on, and framed in the context of your relentlessly optimistic worldview, your conclusions regarding sovereign default are nevertheless troubling. While this may be a zero-sum game for the elite international banking class, doesn't default necessarily entail a currency devaluation? With your personal connection to Argentina, I would expect that you witnessed many everyday Argentinians get destroyed as a result of that country's default in the 90's, yet your piece is silent about the serious ramifications for the common man? The elites in Argentina (and their international cronies) made out swimmingly by buying everything for pennies on the dollar afterward... do you believe, with Arthur Laffer, that all the positives for the elite will eventually "trickle down" and all will then be forgiven?

Argentina defaulted, devalued it currency, and then its economy boomed.

Not sure Greece has the devaluation option.

People take a risk when they buy bonds. Not sure extraordinary measures should be taken to help out Greek bondholders.

Sovereign debt may become more expensive.

However, since there is plenty of capital in the world, not sure that investors have any other place to go.

Interest rates should stay low for generations.

The USA is also lucky in that our debt is dollar denominated. We can simply inflate our way out of debt. Running 5 percent inflation for five years or so would reduce our debt outstanding by 25 percent.

FGH: I have indeed seen the consequences of Argentine defaults and devaluations, and they are terrible. Especially for the common man, who doesn't know how to defend himself. I think what ARgentina has done over the years is akin to armed robbery, and deeply sinful. There are no trickle-down benefits from devaluation, no sir. If anything trickles down post-devaluation, it is poverty. But defaults don't need to result in devaluations, especially for countries that use the euro.

Oops, you appointed yourself "pundit" before you figured out the very basics of modern money supply.

Central banks directly control the supply of base money (except the rate at which currency is lost or destroyed). Central banks indirectly regulate the supply of broad money, by changing the supply of base money and/or the interest paid on base money when it is held in special accounts at the central bank called reserve accounts.

Commercial banks control the supply of broad money. When a commercial bank expands its total lending, it creates new broad money. When a commercial bank decreases its total lending, it puts broad money out of existence. Commercial banks decide how much broad money to create or destroy based partly on market conditions and partly on the broad money supply and interest paid on reserves.